If there is one thing I can guarantee in life, it will be that you are going to pay taxes. The way taxes are treated for individuals are different from the way it is treated as a business. As a wage earner you have the least control of when and how you get taxed. Running your business through a legal entity gives you more flexibility. This is one area you will want to consult an expert as to what entity lets you keep more of your hard earned cash.
Taxes play a big role in any wealth building strategy and the amount you pay depends on how you earn income. In this article I talk about earning income as a wage earner, sole proprietor, general partnership, C corporation and S corporation.
A wage earner is someone who works for a business and in return receives wages or salaries. As a wage earner, your employer is obligated to withhold some of your earnings for taxes. Your employer is also required to pay half of your social security and medicare taxes. Social security and medicare taxes are savings accounts enforced by the US government in which you reap the benefits when you are 65. In addition, your employer has to pay federal and state unemployment taxes on your behalf. The unemployment tax acts as a buffer to keep you from becoming destitute if you lose your job.
A wage earners deduction for business expenses are limited to 2% of wages, which is something you don't run into if you have a business. Moreover, if you do not have enough expenses to itemize you lose the deduction. As an employee you are dependent on your employer for structuring your salary in a way that saves you the most money. Benefits like health insurance or expenses, reimbursable expenses, retirement benefits and fringe benefits * all have different tax consequences depending how it is structured.
* A fringe benefit is a form of payment for services rendered. For example, lodging on your business premises, using a business car for personal use, employee discounts, etc.
By default when you start your business you are a sole proprietor. As a sole proprietor 100% of your income is subject to self-employment tax. Self-employment tax can be compared to payroll taxes for the wage earner and consists of medicare and social security taxes. Unlike the wage earner where the employer pays half of the payroll taxes, you are responsible for paying 100% of your self-employment taxes.
On the other hand, you do not pay taxes on every penny you make because you are allowed deductions for expenses. Even though you have a little more flexibility than the wage earner when it comes to structuring transactions, the sole proprietor is still subject to the highest overall tax rate when compared to other legal entities.
A general partnership works like a sole proprietorship with more than one owner. The IRS does not consider partnerships as separate from its owners. Partnerships are considered pass through entity. This means that all profits pass through the business directly to the partner's tax returns.
Partners get taxed on their income whether they receive it or not. Like a sole proprietor, if you are actively involved in running the partnership, you pay self-employment taxes on your income.
Unlike a partnership, a corporation is not a pass through entity and pays its own taxes. Corporations are the best form when it comes to getting the most tax advantage for fringe and employee benefits.
Corporations are also great if you will like to go public or keep the earnings in your business. The first $ 50,000 of profits are taxed at a 15% tax rate which is probably less than the tax rate of the shareholders / owners.
The big problem with the C corporations is that if the shareholders choose to distribute profits rather than retain it in the business, they get taxed again on their personal tax return. This is called double taxation – shareholders get taxed on the corporate level and then on their personal tax returns.
Due to the fact that corporations are double taxed on earnings, most small businesses choose to form the S corporation. An S corporation is not a legal entity but an election made with the IRS. The S corporation combats the problem of double taxation.
When the election is made, the S corporation agrees to pass the corporate income, losses, and deductions to the individual shareholders. The shareholders are then taxed at their individual tax rate.
Unlike a general partnership or sole proprietor the S corporation only pays self-employment taxes on wages paid to shareholders and not on all income made. In addition to self-employment taxes, the S corporation also has to pay unemployment taxes on wages. The net left over flows through to the shareholders and is taxed at their personal tax rate thus alleviating the problem of double taxation. The S corporation has the potential to save shareholders the most taxes when compared to other structures.
There are other variations of entities but I have discussed only the sole proprietorship, general partnership, C corporation and S Corporation here. Forming a legal entity has the potential to save on taxes. No wealth planning strategy is complete without planning for taxes. If you do not plan taxes in advance you can pay up to 50% of your income in taxes. So much for working hard!
As always contact your Certified Public Accountant for more specific advice.